CIO WM Research 8 January This report has been prepared by UBS Financial Services Inc. (UBS FS) and UBS AG. Analyst certification and

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1 CIO WM Research 8 January 2015 High yield bonds US loans well positioned We believe US loans exhibit several positive attributes, including: 1) improved valuations as prices now trade at discounted levels; 2) lower energy exposure compared to HY bonds; 3) the secured status of loans, with default rates expected to rise modestly from very low levels; and 4) in our view the likely subsiding of outflows from loan funds as we move closer to the first Fed rate hike. We thus think US senior loans, currently offering a yield of 5.9%, are an attractive addition to other fixed income assets for investors able to tolerate phases of illiquidity. US regulatory factors such as leveraged lending guidance and risk retention rules pose potential risks but do not alter our constructive view on US loans at this time. As a credit sensitive asset class, US loans (loans) have been pressured by the recent stress being exerted on the US high yield (HY) bond market. Loans were impacted by the follow-through effects of wider risk premiums and retail fund outflows which began mid-year 2014 but increasingly weighed on the asset class towards year-end. This arose even though the S&P LSTA loan index is significantly less exposed to energy (less than 5%) compared to HY bonds (15%), which have been at the epicenter of the recent correction. Loans produced a total return of 1.6% in 2014, while HY bonds were up 2.5% and investment grade (IG) corporate bonds with 1-5 year maturities generated a total return of 2.0% for the year. At the same time, loans exhibited a considerably lower return volatility of 1.8% compared to 4.9% for HY bonds (on a monthly basis). Loans underperformed HY bonds in 1H14 (loans +2.6% and HY bonds +5.6%) but outperformed during 2H14 (loans -1% and HY bonds -3%). During the fourth quarter correction, loans had a drawdown of 2.3% peak to trough, whereas HY bonds were down 5%. This reflects the post-crisis trend of loans underperforming bonds during periods of strong market conditions but outperforming during market stress. The correlation in weekly returns between HY bonds and loans has risen since it hit a postcrisis low in the summer and loans have succumbed to recent market pressure. Barry McAlinden, CFA, strategist, UBS FS barry.mcalinden@ubs.com, Philipp Schöttler, strategist, UBS AG Thomas M Keller, analyst, UBS AG Source: UBS database Fig. 1: Performance in 2014 (USD) Total return since 31 December 2013, in % Dec-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 Dec-14 IG Corp 1-5yr S&P LSTA Loans US HY IG Corporate Treasuries Source: Bloomberg, UBS, as of 31 December 2014 Fig. 2: US leveraged loan retail fund flows in USD 1, ,000 Aug13 Oct13 Dec13 Feb14 Apr14 Jun14 Aug14 Oct14 Dec14 Daily flows 30 day moving average Source: S&P LCD, Lipper, UBS, as of 2 January 2015 This report has been prepared by UBS Financial Services Inc. (UBS FS) and UBS AG. Analyst certification and required disclosures begin on page 5. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

2 Valuation The price level of the S&P LSTA loan index is currently at USD 95.92, which is the lowest since September Loan prices are capped near par given the continuous call features of the securities. Therefore, a discounted level now allows for moderate appreciation should market conditions improve. The spread to three-year takeout finished the year at Libor plus 562bps, up from a low of Libor plus 444bps during the summer, and stands at the widest value since December With Libor currently at 25bps, this amounts to a current loan yield of 5.9%. As loan defaults are expected to remain low in 2015, any reductions in income stemming from credit costs should be minimal. As a result, we believe that a total return of 5% to 6% represents the expected return range for loans over the next 12 months under our baseline scenario. Under a more positive scenario, where loan prices appreciate, greater return potential exists in the upper-single-digit range. US loans historically yield less than HY bonds due to their senior ranking and shorter duration. As HY bonds have cheapened relative to loans, this yield gap has increased as measured by the difference between the loan index yield to three-year takeout compared to the HY index yield-to-worst. The gap reached as low as about 20bps during the summer, which increased the appeal of loans relative to bonds. Currently the gap stands at 80bps, indicating that the relative appeal of HY bonds has increased. Part of this stems from the higher energy sector concentration of HY bonds, which is where their spreads have widened the most. Fundamentals In terms of fundamental trends, the average leverage multiple for loans as measured by debt/ebitda has increased towards the 5x level in recent quarters, which corresponds to the 2004/2005 time period. Looking at the average debt multiples of large leveraged buyout loans and highly levered loans shows debt multiples near the 2007 peak. As part of the annual US Shared National Credits (SNC) leveraged lending guidance jointly issued by the US Federal Reserve, Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency (OCC) that went into effect in 2013, US regulators highlighted leverage in excess of 6x, debt servicing capacity (i.e. the ability to repay 50% of total debt over 5 to 7 years) and the absence of financial covenants as key factors. According to their most recent review published in November 2014, a third of US leveraged loans do not meet their underwriting standards. While the credit cycle has thus clearly matured over the past quarters, we think current leverage is sustainable thanks to healthy and rising corporate earnings and record-low interest costs. Fig. 3: US loan and HY bond prices at discounts in USD HY Index price Loan Index price Source: BoA, S&P LCD, UBS, as of 31 December 2014 Fig. 4: Yield gap: US loans vs. HY bonds in bps Source: BoA, S&P LCD, UBS, as of 26 December 2014 Fig. 5: US loan leverage ratios multiple All loans Large corporate loans Large LBO loans Source: S&P LCD, UBS, as of 30 September 2014 Additionally, default rates for loans remain benign. The trailing 12- month default rate of the S&P LSTA index was just 2.85% at the end of November, below the historical average of 4.5%. We believe this rate will remain low in 2015, below the HY bond default rate owing to the lower energy exposure in the loan index. CIO WM Research 8 January

3 Deficiencies found in leveraged lending The results of the annual SNC review were disclosed in early November. Multiple Federal regulators examined loans exceeding USD 20m that are shared by three or more supervised institutions. Deficiencies were found in borrower repayment capacity, leverage, underwriting standards, and in the lack of financial covenants. It remains to be seen how strictly the guidelines will be enforced or to what extent this could curtail companies' abilities to borrow. A strict interpretation could limit access to loans for some highly leveraged companies, reduce loan issuance volumes and even lead to a rise in defaults. It could also encourage some companies to refinance via the HY bond market. However, the importance of leveraged lending was noted in the SNC release documents: "The agencies recognize that leveraged lending is an important type of financing for the US and global economies, and that the US banking system plays a key role in making credit available by syndicating credit to investors." On the enforcement side, "The agencies believe that an institution unwilling or unable to implement strong risk management processes will incur significant risks and should cease their participation in this type of lending until their processes improve sufficiently." As a result of these findings, supervisors will increase the frequency of their reviews of these institutions to ensure that risks are well understood and well controlled; those not following guidance will be "subject to criticism by the appropriate agency." The bottom line, in our view, is that the main intention of regulators is to help safeguard against aggressive lending rather than trying to curtail leveraged lending activity, which would be positive for the long-term health of the leveraged loan market. Risk retention rules finalized The second regulatory development falls under the risk retention rules for Collateralized Loan Obligations (CLOs). Some of the Dodd- Frank rules for investments were recently finalized and will require CLO managers to retain 5% risk, the so-called 'skin in the game.' Going into effect on 24 December 2016, these rules are significant in that CLOs comprise 60% of investor demand for newly originated loans. A potentially negative effect of the 5% risk retention requirement could be fewer CLOs, as some managers will struggle to raise sufficient retention capital, thereby shrinking the loan investor base and causing secondary loan prices to decline. We view this as a possible longer-term risk factor that could even result in CLO manager consolidation. In the near term we expect CLO issuance to remain robust, albeit at slightly lower levels, as loan supply and funding conditions remain supportive and managers seek to further grow assets under management before the rules take effect. Another impact of the risk retention rules might be a decline in the role that CLOs have played as a market stabilizer, especially if fund outflows were to persist. It is therefore possible that some incremental volatility could be introduced into the loan asset class over time with CLOs less likely, on the margin, to act as a shock absorber during months of strong supply. Flows into loan funds have been negative during much of 2H14; however, we expect this situation to improve and provide support to the loan market as investors seek out floating rate products ahead of the Fed's expected rate rises beginning in 2H15. Fig. 6: Primary market for institutional loans CLO 60.6 Finance Co. 0.7 Insurance Co. 5.2 Hedge, Distressed & High- Yield Funds 11.1 Source: S&P LCD, UBS, as of 30 September 2014 Loan Mutual Funds 22.5 Fig. 7: S&P LSTA Loan Index sector weights in % Sector Weight Health care 8.8% Electronics/electric 7.9% Business equipment and services 7.7% Utilities 6.0% Hotels/motels/inns and casinos 5.6% Retailers (other than food/drug) 4.8% Oil and gas 4.5% Telcommunications 4.2% Chemical/Plastics 4.1% Leisure 3.6% Food products 3.2% Cable television 3.2% Publishing 3.1% Broadcast radio and television 3.0% Food service 3.0% Financial Intermediaries 3.0% Automotive 3.0% Industrial equipment 2.4% Insurance 2.0% Aerospace and Defense 2.0% Source: S&P LCD, UBS, as of 22 December 2014 US senior loans an attractive addition We think US senior loans, currently offering a yield of 5.9%, are an attractive addition to other fixed income assets. Key positive attributes of loans include: 1) improved valuations as discounted loan prices allow for price gains; 2) less than 5% of energy sector exposure in the loan index as energy companies tend to use bank revolvers over term loans; 3) the secured status of loans, with default CIO WM Research 8 January

4 rates expected to rise modestly from very low levels; and 4) in our view, the likely subsiding of outflows from loan funds as we move closer to the first Fed rate hike. Given the speculative-grade nature of loan issuers and low secondary-market liquidity, we recommend that senior loans be considered by qualified investors who can tolerate phases of illiquidity. CIO WM Research 8 January

5 Appendix CIO WMR Corporate Bond Ratings Definitions Rating Definition Given our view of credit risk and valuation, we believe the bonds of these issuers may offer higher total return over the holding period relative to the bonds of other similarly-rated issuers. This performance may be driven by the bond s coupon income and potential for credit spread tightening. We regard Attractive securities on the Attractive List as appropriate for investors with a moderate to high tolerance for credit risk due to the possibility of somewhat greater credit spread volatility relative to other investment grade corporate bonds. Investors should review the issuer-specific comments in light of their risk tolerance profile and in the context of their overall portfolio. Issuers we deem to be Core Holdings offer relatively liquid bond curves and comparatively stable credit profiles. We generally expect bonds of these issuers to perform in line with their benchmarks as spreads Core are unlikely to tighten or widen more materially than peers. We regard securities on the Core List as most appropriate for fixed income investors with a low-to-moderate credit risk tolerance and a holdto-maturity strategy. We deem bonds to be Unattractive for fundamental reasons based either on an anticipated deterioration in an issuer s credit profile or valuation reasons based on the bond s rich credit spread level. In the case of fundamentals, bond valuations may be cheap but we have concerns that credit fundamentals may deteriorate, causing spreads to widen further. In the case of valuation, we believe Unattractive that spread levels do not adequately compensate investors for the credit risk inherent in the bonds. In this case, we believe credit spreads are rich and have potential to widen. The rationale for placing bonds on the Unattractive List will be detailed in the issuer-specific comments, in coordination with the issuer s credit quality indicator. CIO WMR Credit Quality Indicator Definitions Rating Definition The issuer demonstrates credit metrics that are in line or better than peers. We believe bonds are likely High to exhibit average to below-average credit spread volatility. The issuer demonstrates credit metrics that are in line to slightly weaker than peers. We believe bonds Medium have potential to exhibit above-average credit spread volatility. These securities should therefore only be held in diversified portfolios of risk tolerant investors. The issuer demonstrates credit metrics that are weaker than peers. We believe above-average credit Low spread volatility is likely to occur. These securities should therefore only be held in diversified portfolios of the most risk tolerant investors. Statement of Risk Bond market returns are difficult to forecast because of fluctuations in the economy, investor psychology, geopolitical conditions and other important variables. Corporate bonds are subject to a number of risks, including credit risk, interest rate risk, liquidity risk, and event risk. Though historical default rates are low on investment grade corporate bonds, perceived adverse changes in the credit quality of an issuer may negatively affect the market value of securities. As interest rates rise, the value of a fixed coupon security will likely decline. Bonds are subject to market value fluctuations, given changes in the level of risk-free interest rates. Not all bonds can be sold quickly or easily on the open market. Prospective investors should consult their tax advisors concerning the federal, state, local, and non-u.s. tax consequences of owning any securities referenced in this report. Analyst certification Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers; and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report. CIO WM Research 8 January

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